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October 3, 2012

Not All ETFs Are Created Equal: What to Consider

To say the market for exchange traded funds—ETFs, as we all know them—has virtually exploded in recent years would hardly be an understatement. Well regarded for a number of positive attributes, not least of which are transparency, lower costs, ease of trading and even a degree of tax efficiency, the exchange traded universe has expanded to include something on the order of 4,700 products representing around $1.75 trillion in assets. But amid the steady stream of new ETFs coming to market, wealth managers and their clients need to recognize that not all offerings are, or have been, created equal. In fact, there are a number of considerations to make before choosing an ETF for investment.

While ETFs are typically built to track a specific index or asset class, to expect them to fully replicate return or yield results of those indexes or classes would be a mistake. Why? Because every ETF has a measurable degree of tracking error. And some have more than others—funds that utilize ‘representative sampling’ in particular. These strategies invest only a portion of the fund’s holdings in the underlying index and use optimization to supplement the rest. Predictably, when the index is made up of holdings with low trade volume, like many foreign markets, large tracking error can occur. Witness, for example, the performance of the iShares MSCI Emerging Markets ETF (EEM). The fund lagged its index by 4.8% in 2007, outpaced it by 3.3% in 2008, then trailed again in 2009 by 6.71%.

Price and NAV; Lack of Liquidity

There’s also the occasional issue of an ETF’s price in relation to its NAV. Typically, a fund’s valuation difference is moderated by design through an underlying arbitrage opportunity, but in turbulent markets this mechanism tends to break down. In June, for example, the market whirlwind surrounding Greece’s financial position accelerated the volume of the Global X FTSE Greece 20 ETF (GREK) to the point it was trading at nearly a 10% premium to its NAV.

Similarly, a lack of liquidity, i.e., when the creation of new shares of a fund cannot keep pace with inflows, can cause pricing issues. The high-yield bond ETF space, where underlying securities can be difficult to find due to over-the-counter trading, often sees investors overpaying for the underlying holdings. This was the case for the iShares High Yield ETF (HYG) at the end of 2011. Finding a representative basket of bonds was so tough at the time that shares of the fund traded above their NAV. Ultimately, as liquidity improved, the creation of new shares wiped out the premium and caused a discount to NAV. Investors who sold in early 2012 actually received less than the value of the underlying holdings.

Not Everything’s Simple

In the meantime, a bevy of more exotic ETFs have come along to meet the seemingly insatiable demand for indexing products. Some deal in futures, some in swaps, some in commodities. Whatever they deal in, these ETFs can be risky if misunderstood and investors should not confuse them with plain vanilla ETF offerings. Gaining exposure to commodities through an ETF does not mean that fund returns will be commensurate with movements in commodities prices. An oil ETF, for example, will not necessarily track the market price of oil because of term structure.

Leveraged and inverse ETFs also have their nuances, and investors need appropriate expectations of how these specialized offerings will perform. These self-described funds are designed to provide some kind of variant to the target index on a daily basis, and, as such, are rebalanced on a daily basis. This important caveat can produce results seemingly counterintuitive to the funds’ labels. Here’s how: If over a period of time, the market trended downward, but with enough volatility to include a good number of outsized positive days, an inverse ETF could actually produce a negative return in the very market environment it would be expected to flourish.

Imagine this effect multiplied with an investment in a 3x inverse ETF. The truth is that these instruments carry a degree of risk not apparent at first glance. As such, they’re more than likely not suitable for the average investor.

Don't Worry, There’s Still Choice

The bottom ETF line is this: Before investing in an ETF to gain market exposure, research the various aspects of the specific product and ask several questions of the approach. At the very least, determine if there is sufficient trading volume and assets under management to maintain a good level of pricing stability. If the fund is selling at a premium, consider purchasing a mutual fund as an alternative for market exposure. Know, too, whether the ETF uses full replication or representative sampling to follow its target. If the latter, understand how the fund seeks to track the index.

While there are good reasons for the popularity of indexed investing to be so high, knowing there are some risks involved and understanding their impact remains paramount. Inexpensive market exposure is great, but investors are often better served paying for the expertise of active management, particularly in certain asset classes.

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Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.